Lecture 8 - 1 of 42 Chapter 9 IS-LM Model 2 of 42 Questions 1 What is the IS curve 2 How do changes in interest rates affect the equilibrium level of

Lecture 8 - 1 of 42 Chapter 9 IS-LM Model 2 of 42 Questions...

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of 42 Chapter 9 IS-LM Model 1
of 42 1) What is the IS curve?2) How do changes in interest rates affect the equilibrium level of production and income in a sticky-price model?3) What determines the money market equilibrium with sticky prices?4) What is the LM curve?5) What is an IS shock?6) What is an LM shock?7) What is the IS-LM equilibrium? 8) How do different shocks affect the IS-LM equilibrium? Questions 2
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of 42 A higher interest rate reduces autonomous spending (A) by reducing investment (I r r) A higher interest rate also reduces autonomous spending (A) by reducing net exports •Recall ε = ε 0 − ε r (r − r f ) Hence, when r increases ε falls, reducing net exports In chapter 8, we keep r as given and fixed. Now we see that r plays an important role in the determination of the equilibrium. Aggregate Demand: Autonomous Spending 4 ) ε X + Y (X + G + r) × I - I ( + C = A ε f f r 0 0 r ) X (I - )] r X X Y (X G I C [ A r r f r f f 0 0 0
of 42 Aggregate Demand: Autonomous Spending 5
of 42 Because a change in the real interest rate changes autonomous spending, it will change the equilibrium level of real GDP the effect will be equal to the interest sensitivity of autonomous spending (I r + X r ) times the multiplier IS curve The relationship between the level of the real interest rate and the equilibrium level of real GDP Investment-Saving (IS) Curve 6 r ) X (I - )] r X X Y (X G I C [ A r r f r f f 0 0 0
of 42 IS Curve 7
of 42 •Define baseline autonomous spending(A0) to include the determinants of autonomous spending that do not depend on the real interest rate)] IS Curve: Equation 8 r ) X (I - )] r X X Y (X G I C [ A r r f r f f 0 0 0
of 42 The term on the left is the horizontal intercept of the IS curve The term on the right is measures the responsiveness of real GDP to changes in the interest rate Since r is on the y-axis, the slope of the IS curve given by: IS Curve: Equation 9 r ) IM - t) - (1 (C - 1 ) X (I - ) IM - t) - (1 (C - 1 )] r X X Y (X G I [C Y y y r r y y f r f f 0 0 0 Y ) X (I ) IM - t) - (1 (C - 1 - ) X (I )] r X X Y (X G I [C r r r y y r r f r 0 f f 0 0
of 42 IS Curve: Graph 10 The IS curve plots for each r the corresponding Y that is consistent with equilibrium in the goods market The IS curve plots for each r the corresponding Y that is consistent with equilibrium in the goods market
of 42 The first term is the inverse of the multiplier (1/1-MPE) The second term shows how large a change in investment or exports is generated by a change in the real interest rate IS Curve: Slope 11 ) ε X + (I MPE - 1 - = ) ε X + (I ) IM - t) - (1 (C - 1 - = slope IS r ε r r ε r y y
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